One of the great things about our role as wealth advisers is that we get a window into the lives of some incredibly successful people. We often work with clients with fairly large IRA balances—some exceeding $2,000,000. For clients with a legacy intent, the passage of the SECURE Act in December 2019 created some new estate planning challenges.
How did it work before?
Previously, when one of your heirs inherited an IRA, they would be able to establish a separate IRA from the rest of their accounts called an inherited IRA. Their share of your IRA would then transfer into that inherited IRA. They would be required to take out a certain percentage of the inherited IRA as a required minimum distribution (RMD) every year. The amount they needed to take was based on their life expectancy and increased slightly each year. This was referred to as a stretch IRA, as it allowed beneficiaries to stretch the withdrawals out over the rest of their lives. That allowed the money to continue growing tax-deferred over time.
For example, if someone inherited an IRA at age 45, IRS table 1 says they need to take their year-end balance and divide that by 38.8, subtracting 1 from that factor each additional year. This means in the first year, they have to take out roughly 2.58% (1 / 38.8 = 2.58%). So, if they inherited $1,000,000 worth of an IRA, their RMD would have been $25,800.
With the passage of the SECURE Act inherited IRAs from those who passed after December 31, 2019 must follow new withdrawal rules. Each of your heirs can still open an inherited IRA, but they are no longer allowed to stretch the withdrawals over their life expectancy. Instead, they are now required to withdraw all of the money by the end of the 10th year following your death. They have option to take that money out in whatever intervals they want, so long as the account is empty by the end of the 10-year window. If we assume that they opt to take the money out evenly, they will need to withdraw roughly 10% of the starting balance of the IRA each year. For our example beneficiary, rather than having to take out $25,800, they would now be taking $100,000 out.
Why does this matter?
If your beneficiary takes out $100,000 from their inherited IRA, that $100,000 will be added to their income for the year. For many people who have a $100,000 increase in their income, that additional income will very likely be taxed at a higher rate than what they are normally used to paying taxes on. This is particularly true when you consider that many people are in their prime earning years when they lose their parents.
If we imagine your beneficiary is a police officer making $80,000 a year and they’re married to a teacher making $60,000, after the $24,000 standard deduction, their taxable income is normally $116,000 per year, putting them in the 22% bracket. If we add another $100,000 on top of that, the first $56,000 would be taxed at 22%, but the next $44,000 would be taxed at 24%. While that doesn’t sound terrible (they are inheriting a million dollars, after all), having higher income can affect other things, such as college financial aid, the cost of health insurance (for those purchasing health insurance through the marketplace), and potentially other areas you might not ordinarily think of as connected to your income
What can you do?
The first thing worth doing is taking stock of your own tax situation and how it likely compares with your heir’s tax situation. It’s not uncommon for us to see clients with high assets, but low taxable income. If your income puts you in a lower tax bracket than your heirs are likely to be in, perhaps it’s worth considering doing some Roth conversions.
When someone inherits a Roth IRA, they can open an inherited Roth IRA. They would still be subject to the same 10-year payout rule as traditional IRAs, but with an inherited Roth IRA, gains would not be taxed, and withdrawals would be tax free. If you are currently in the 12% bracket (taxable income below $81,050 for married couples filing jointly), it would probably be worthwhile to convert a portion of your IRA to a Roth IRA if your kids are likely to be in the 22% bracket or higher. It’s worth remembering that the tax rates move significantly higher at a lower level of income for single beneficiaries than they do for married beneficiaries. It’s definitely a good idea to map out exactly what their income might be like.
You should also consider what will likely be happening at the time your heirs are likely to receive these assets. If you are expecting them to inherit these accounts near the end of their working careers, they could consider taking advantage of the flexibility of the 10-year rule when determining when and how much to take in withdrawals. For example, let’s say someone was 63 when they inherited an IRA and that they plan to work until age 65. They could opt not to take any distributions in the years that they are still working (ages 63–64), and then take the distributions out equally over the remaining eight years (Age 65–72) once their wages have stopped.
The one wildcard here is that no one knows what rates are going to be in the future. Even if the current administration is true to its word and doesn’t increase taxes on anyone earning less than $400,000 per year, the current rates we have in place are set to expire and revert back to higher rates in 2026. With large budget deficits, it seems inevitable that taxes will be increasing in the future.
Most of the proposed tax increases seem to be directed towards higher-income individuals, but there’s no telling how far down into the middle class these tax increases will need to go. The good news is, the government is only going to tax the rich. The bad news is they might decide that you’re rich, too.